Tuesday, July 20, 2010

I'm in Johannesburg now and traveled overnight to get here from Cairo and we've been out in the country touring all day, so I can't spend much time on this. Housing starts were weaker than expected, but they are still up 15% from their lows of last year. I still think we've seen the bottom in housing. Construction is so far below the level needed to keep pace with new family formations that inventories are being worked off and this will almost guarantee stronger construction activity in the years to come. I haven't expected to see a strong recovery in housing in any event—I've been calling for a gradual increase over the next year or so—so this data looks to be consistent with that.

22 comments:

Hi Scott,looks like you are having a great vacation.I was wondering if you could comment on the banking industry. I have been reading a lot of dick bove and meredith whitney lately and would like to know what you think the future holds for the big banks and how they could either help the economy or harm the economy.Can we argue that they are a leading indicator for the market more so than housing starts?

Am enjoying your trip vicariously. I am truly surprised you continue to blog as you go. I for one am thankful. The pictures are terrific.

A couple of things of note today:

1) I am reading of RUMORS that the Fed is about to eliminate the .25% interest it pays member banks on their deposits at Federal Reserve banks. If this in fact occurs, I will have been wrong and Benj right on the need for additional fed action!

2) Spain's banks have passed their stress tests and are trading higher.

3) BHP Billiton (BHP), Vale (VALE), and Freeport McMoran (FCX) have held above their lows and are all trading strongly higher today. These are all commodity/economy sensitive equities.

4) Pepsi (PEP) released excellent earnings this AM. I cannot offhand think of a better growth and income story for a conservative investor unhappy with bond or CD yields. World class brands (Gatoraid, Frito Lay, Pepsi among MANY others), terrific, proven management, high exposure to fast growing emerging markets, 3% AND GROWING yield, appreciation potential with low volatility. If this appeals to anyone, do your own homework before taking action

5) High yield bonds are near their cycle highs (in price). If deflation/ double dip were feared the market logically should sell these off fearing rising defaults.

We still face many headwinds. The burden of proof for ~$83 S&P EPS this year and ~$90 next remains with the bulls. If there is no double dip recession there is a reasonable chance those targets could be hit.

Scott is on vacation. We are fortunate he is blogging at all. Out of respect for our host I suggest we wait for his return to request answers to specific questions from him. He undoubtedly will read the posts as he has time and may choose to answer but lets not look for it.

We have a lot of VERY good posters on this blog. Some may enjoy discussing questions posed by others.

Disagree with the housing starts showing anything positive.This series will be of an "L" curve shape.

Historical average volume is still many years away. That build rate would represent a 100% increase over these historic lows, yet won't be attained for several years into the future.

Why? The ramp-up to building houses has a LONG lead time and requires a lot of capital. This abundance of "patient" capital with multi-year horizons for the homebuilding industry is a pipe dream in this environment.

Many public builders (the healthy ones of the group, btw) have market caps that are either at or below their cash balances!

A lot of this near term volatility was because of home buying tax credit "pull-forward". Starts will be flat until there's stabilization/increase in household formation, strong employment growth (3M+/Year) and the foreclosure issue overhang gets cleared out.

But I have noticed an increased number of Fed speeches, and studies, on the topic of quantitative easing on their website. It is purprising this has not received more recognition.

Frankly, I think the Fed knows we face a deflation spectre. The CPI is down three months in a row, and PPI is sinking too. Unit labor costs have been falling for a year, and all real estate is soft to down in prices and rents. And not getting better.

Deflating real estate is a killer--borrowers walk from deflating property, leaving behind unpaid mortgages. Guess what that does to our banking system.

Too, many, many business use real estate collateral for expansion capital (including me!).

This is not a time for shibboleths and nostrums. As a nation, we have decided deficit spending as gone far enough (even if we all think the other guy's programs are the ones that should be cut).

Okay, that's leaves monetary stimulus. And we are in a liquidity trap.

Companies are making money by slashing costs, not growing top-line numbers. Also, companies will need cash on-hand versus the heady days of borrowing until the sun didn't shining.

And do you really think Spanish banks passed any kind of test? It is all a load of hogwash. They transferred their risk to the sovereigns therefor it still exists in the system.

Benj, the Fed is the problem and they have no clue what their actions do to the economy. During the 'Great Moderation' the Fed thought it was in control when really it was simply a spectator adding additional fuel to the fire.

Until we delever and purge the system of crummy companies, balance sheets, and Keynesian ideas, ergo more of the same.

Residential housing will creep up at a 10% annual pace for the next five years. There is no hope for this sector to drive the economy forward. We can ignore it.

Gradually the housing inventory is being worked off but people are doubling up or moving in with relatives due to the high level and duration of unemployment.

Growth in consumer spending will not drive the economy forward either. Household balance sheets will not permit consumers to spend more.

The way forward is investment directed to export markets, import substitution and cost reduction. The way to achieve that is to cut back drastically on government regulation, reduce taxes on investment and take steps to reduce the long-term burden of government on the private sector. Obama has been doing the opposite so all we see is the end of the inventory cycle and trendline growth rates off a very low base.

Thank you. If anyone is looking for top line growth the search ends here.

Sales were $15.7 Billion up 60% year over year. They have guided to $18 Billion for the fourth quarter. It will likely be topped.

EPS was $3.51, .40 ahead of consensus.

The i-Pad shipped 3.27 million units in 10 countries, well ahead of expectations. There were 3.47 million Macs sold. The order book is backlogged. Earnings would have been higher had they been able to meet demand. There are years of growth ahead for this amazing company. Their market share is still low.

Those pooh poohing this I respectfully invite to short. Be sure to let us know when and at what price.

I just made a post on my blog about the Spanish.. here's a few factoids: "Spanish banks borrowed a record 126.3 billion euros ($161 billion) from the European Central Bank in June. This represents a 48 percent increase from the €85.6 billion borrowed in May" and "The just completed auction of Spanish 2025 Obligacions for just under €3 billion, came at a 5.116% yield, a substantially worse level than the last auction as of April 22, which was placed at 4.434%"

Sorry, but from where I sit {admittedly not as exotic or hot as Egypt or SoAfr} Spain's situation looks to be deteriorating.

In my opinion we will not be successful in bringing unemployment down without a healthy and profitable banking industry. Having said that, many bankers have been less than honorable in their business dealings in the last few years so it has become necessary to involve the industry with more government oversight and regulations, the effects of which may not be fully apparant for years. Thousands of books and articles are available on the subject. I suggest you begin with "PANIC" by Andrew Redleaf and Richard Vigilante. Scott has commented on this work and some of the fine posters on this blog have reviewed/commented on it.

Mr. Bove and Ms. Whitney offer what appear to be opposing viewpoints of the banking industry and its prospects today. I am not familiar with all of the arguments but it appears to me that the Federal Reserve is slowly reliquifying the banks by holding short term interest rates at near zero levels. Something similar occured in the early 1990s after the real estate collapse then and the banks recovered and prospered for many years. It is my belief the same thing is occuring now and bank stocks will be quite good investments GENERALLY in the intermediate to long term.

Other posters here have differing opinions and may choose to contribute to the discussion. As always, there are many points of view.

Benj, the Fed is the problem and they have no clue what their actions do to the economy. During the 'Great Moderation' the Fed thought it was in control when really it was simply a spectator adding additional fuel to the fire.

I think this summary strikes at the core of what has happened. Sadly, it appears it is a summary of what is still happening: The Fed still thinks it is in control. This time, however, I don't think it will take 10 or 15 years for the consequences to appear. The self fulfilling deflationary fears now growing in our collective brains can only be subdued with overwhelming evidence to the contrary. If the Fed produces such convincing evidence, the pendulum is almost sure to swing widly and rapidly to self fulfilling inflationary fears. The Fed thinks they will be able to control inflationary fears as well, but this time I think even they will realize they aren't in control, and the markets are in control to take this house of cards back into a grounded reality.

We are not in an era of inflation nor are we in an era of deflation: we are in an era of instability!

No offense to John's point of view, and looking at US banks only, the fundamental problem is that because of FASB 157, the investing public has no idea as to the composition, and the fair market value of the banks' asset.

Just as an example US banks are carrying $840 billion in second mortages at par, does anyone believe that there is no impairment on that book?

Fundamentals is that if you cannot understand the business and assets of a company you should stay away.

By law investors are prohibited from knowing (eg FASB157) from knowing the true value of the banks.

It may sound old school but rule one of investing is: understand the asset.

You have articulated well my primary objection to building/storing wealth in a bank stock. The average investor has no idea what, specificly, a bank's assets are. It requires a huge leap of faith, or an intimate knowledge of the character of a bank's management to be a long term investor in a bank. I got a brutal reminder of this during the 2008 bank meltdown. I was fortunate to have reduced my positions substantially prior to the final plunge but I was still in too much.

Investing in banks requires no small amount of nerve but history has shown that the best times for bank stock investors are when credit risks are improving. The recent earnings releases from JP Morgan, Citigroup, Wells Fargo, and others are all pointing precisely that way. IMO the crisis is behind us and quality bank stocks will reward investors handsomly over the next few years.

Good point with regards to the recovery. I'm also firmly of the school of no double dip, although not a strong recovery.

The question as to the right time to invest in banks is a good one. From my point of view this is not a normal recession, it is a deleveraging exercise by overstretch borrowers. I don't know if you follow Bronte Capital http://brontecapital.blogspot.com/,but he really articulates my dilemma with regards to banks.

If we are in a Japan mode, all bets are off. The issue here is not the amount of cash on companies balance sheet -- it can be shown that by all historical standards the amount is large, but within the range of what companies have done for some years, if its of any interest the ration for Canadian companies is even higher), rather has credit quality improved? If good borrowers are reducing their borrowings (corp and individuals) those who remain are of worse quality. BTW, JPM indicated that they don't believe that the next quarterly result will see a further reduction in loan loss reserves.

Lets look at big bank that I believe is characteristic of what I have been trying to say: First, full disclosure, they bought my old securities firm A.G. Edwards & Sons and their securities unit has been merged into our home office in St. Louis. The bank is Wells Fargo. They bought Wachovia Bank and are now coast to coast. I still own shares of Wells.

They clearly stated on the conference call they are seeing improving credit quality. Some of it is tighter lending standards. They are not saddled with the currency translation and capital market issues many moneycenter banks have. And I strongly doubt they own any Greek bonds.

Wells released $500million in loss reserves in the quarter. More will likely be released by yearend.

Earnings were $3.1Billion and $.55 per common share. The net interest margin was 4.38%, return on assets was 1%, and return on tangible common equity was 14.6%. These are stellar numbers for this environment.

Very importantly credit quality improved across the board:

1) Charge offs were down 16% from the 4th quarter '09 peak.

2) Commercial real estate losses were down 10%

3) Consumer losses were down 21%

4) Revolving credit card loan charge offs were down 34%

5) Thirty day past due improved in credit cards, student loans, mortgages, and home equity.

6) Tier 1 common equity ratio improved 44 basis points to 7.53%

As for the character of the bank's management, Warren Buffet said during the depths of the credit collapse he was willing to buy the entire bank when it was under $10 per share if he could have. Berkshire still owns a huge hunk of the stock.

This bank has huge operating leverage into a gradually normalizing economy...and they are NOT stressed now. They have problems, yes. But they are rapidly working through their problem loans and their new ones are well underwritten.

This is an example of a bank that will earn very large returns for investors in coming years. IMO it's stock is on the bargain counter. It will not be forever.

Do not beat yourself up. The media is full of pessimists and the doom&gloom merchants are given large amounts of air time.

When I was working I would constantly test my convictions with what I called the 'ease indicator'. It is predicated on the assumption that every decision is either right or wrong. If it felt easy to do, it was probably wrong. If it was difficult, the probability of being right improves. Some of my worst mistakes occured when I was excited (positively or negatively) and some of my very best ever investments initially left me literally nauseated after entering the order. It is certainly not perfect and is intended as simply a conviction tester but it has served me well over the years. One other thing: it works best when real money is involved.

Always keep in mind there are as many paths to investment success as there are unique imaginations. What is right for one may be terrible for someone else. Above all, be true to YOUR needs and values...do not try to be someone else.